Identifying Who Is Obligated to Pay: How Merger Advisors Can Protect Their Interests

The dynamic nature of transactions today may lead to unexpected and untimely changes in parties to the transaction—and to the transaction itself.

Depending on the contract language, the party that originally obligated itself to pay may not have the financial wherewithal to satisfy the agreed fee. Or the transaction for which a fee is payable may no longer resemble the transaction actually being consummated. In either case, the advisor may be unable to realize the bargained-for consideration for its services unless it has taken appropriate steps to protect its interests.

A recent series of Delaware cases arising out of the acquisition by Pearl Senior Care of Beverly Enterprises—and concluding with the Supreme Court affirming a lower court decision in MetCap Securities v. Pearl Senior Care Inc.—is a cautionary tale for investment banks and other advisors that frequently enter into contractual arrangements regarding a transaction advisory engagement at a stage when the transaction's shape and direction are quite preliminary.

MetCap Fees to Be Paid by "Parent"

North American Senior Care, Inc. was a shell corporation formed to acquire defendant Beverly Enterprises, Inc. North American entered into an engagement agreement with MetCap Securities LLC to serve as its financial advisor in connection with the Beverly transaction. The engagement agreement was only between North American and MetCap.

Payment of the 1 percent of deal value fee was guaranteed by another entity, SBEV Property Holdings LLC. It is not clear from the published cases what relationship SBEV bore to North American or whether it too was a shell, but there appears to have been some affiliation.

North American, along with SBEV and what appears to be an acquisition sub of North American, entered into a $2 billion cash merger agreement with Beverly. The merger agreement included a standard no broker or finder provision that carved out the MetCap arrangement and provided that related fees and expenses of MetCap would be paid by "Parent," which was defined as North American.

Financing Source Created Series of Entities

Following entering into of the merger agreement, North American went to work finding suitable financing for the transaction. A financing source was located and a series of entities were created by that financing source to carry out the acquisition, including Pearl Senior Care. Rather than buying an equity interest in North American, it was determined that Pearl Care and its affiliates would be the acquiring entities.

Accordingly, an amendment to the merger agreement was prepared that provided for the assignment to Pearl Care by North American of its rights under the existing merger agreement and an assumption by Pearl Care of North American's obligations under the merger agreement.

References to MetCap Fees and Expenses Deleted

For reasons that were never clear, the agreement was further amended late in the evening at a time when principals of North American had left thinking the deal was done. Partners of the law firm representing North American (a firm of which one of the North American principals was also a partner) amended the agreement to delete the portion of the no-broker or finder provision that referred to the MetCap fees and expenses and North American's obligation to satisfy them.

So, at the time of execution of the amendment, there was no obligation relating to the MetCap fees and expenses to be assumed by Pearl Care pursuant to the amended merger agreement and its general assignment and assumption language. Nor did Pearl Care ever separately undertake to assume North American's obligations to MetCap under the advisory agreement.

Court Hears Recovery Claims

MetCap and North American brought claims based on four principal legal theories in an attempt to recover the $20 million fee due to MetCap. These claims were addressed in two different Delaware chancery court actions, the first involving a motion to dismiss and the second a summary judgment motion. The court ultimately ruled for the defendant on all claims.

Claims of Fraud

MetCap claimed it had been defrauded by Pearl Care because MetCap continued working despite the late hour change to the merger agreement made without MetCap's knowledge and as to which Pearl Care remained silent. The court dismissed this claim because MetCap failed to allege any facts giving rise to a duty of disclosure on the part of Pearl Care. Where there is no fiduciary or other obligation, such as in contract, to disclose information, the court indicated there is no duty to speak.

Third Party Beneficiary Status

MetCap argued that it was a third party beneficiary to the merger agreement before its amendment and that as a result the parties could not vary or eliminate its right to a fee without its express consent.

Since it was not a party to the merger agreement , MetCap thus had to allege third party beneficiary status to claim any rights under the agreement. Under Delaware law, the court indicated that establishing third party beneficiary status requires a showing of an intent between the contracting parties to benefit a third party through the contract, the benefit being intended to serve as a gift or in satisfaction of a pre-existing obligation to the third party—and that benefiting the third party was a material aspect to the parties agreeing to the contract. The court did not find it necessary to address this later point.

In the court's view, the reference to MetCap in the exception to the no brokers or finders provision merely reconfirmed North American's obligation to MetCap under the advisory agreement and did not by such recital intend to benefit MetCap. Nor was there any indication that the parties intended to confer a gift on MetCap or that it was a means of satisfying a pre-existing obligation. The provision only restated that obligation of North American.

Finally, the court noted that even if MetCap were a third party beneficiary under the merger agreement, the court was not persuaded that the amendment to the merger agreement changed MetCap's rights to its detriment, since North American remained obligated to pay MetCap's fee before as well as after the amendment.

Contract Reformation

MetCap and North American sought to reform the amended merger agreement to reflect the alleged understanding that Pearl was to assume all of North American's obligations, including the obligation to pay MetCap. With regard to MetCap, the court summarily dismissed its claim for reformation since it was not a party to the merger agreement or its amendment, and reformation is only available to parties to the contract. With regard to North American, the court considered each of the three equitable grounds under Delaware law to "reform" a contract: mutual mistake, unilateral mistake and fraud.

Whether mutual or unilateral mistake, the court indicated that plaintiffs must show a specific prior understanding (the "real" agreement as one case called it) that differed materially from the written agreement. The court did not view the negotiations regarding the amended merger agreement as concluded, even though the North American principals left for the evening and counsel remained to complete the agreement. As counsel was determined to have authority to bind North American following the exit of the North American principals, the court concluded negotiations regarding the fee did not become final until the time of execution of the amended merger agreement; thus, there was no specific prior or "real" agreement regarding the obligation to pay.

Unjust Enrichment

Each of MetCap and North American alleged that Pearl Care was unjustly enriched by the work of MetCap. The court dismissed North American's claim because North American and Pearl Care were already parties to a contract between them. If there is a contract between the complaining party and the party alleged to have been unjustly enriched, the contract is the measure of the parties' rights. On the other hand, there was no agreement between MetCap and Pearl Care.

In analyzing MetCap's claim, the court noted that there must be some relationship between the parties, including a showing, among other things, that the defendant was unjustly enriched by the plaintiff who acted for the defendant's benefit. Prior to the amendment to the merger agreement, the court concluded there was no benefit that could have been conferred on Pearl, only on North American, the party for which it acted under the advisory agreement. With regard to the period following the amendment, the court ultimately granted summary judgment to defendants on the basis that even if Pearl Care were enriched by MetCap's services, it was not unjustly enriched. In reaching this conclusion, the court analyzed the doctrine of an "officiously conferred benefit," which arises when a person who without mistake, coercion or request has unconditionally conferred a benefit upon another. The court found no evidence of mistake, coercion or request regarding MetCap's services following the amendment.

Advisors Must Anticipate Range of Outcomes

With hindsight, this case could be viewed as a simple matter of principal and lawyer carelessness in drafting of the agreement to make sure responsibility for the advisor fees and expenses was properly assumed.

Unfortunately for financial advisors, they are not generally offered a seat at the transaction agreement table and are not otherwise in a position to dictate changes that favor them. It is therefore incumbent on them and their counsel to anticipate events and to craft the engagement agreement broadly enough to capture a range of outcomes that will assure payment of fees. Consider, for example, the following:

• Consider the party. Whenever possible, the advisor should enter into the agreement in the first instance with a creditworthy party of substance. This is a consideration, not only with respect to fees, but indemnification as well.
• Obtain third party guarantees. If circumstances dictate that a shell corporation must be the adviser's counterparty, the advisor should arrange for third party guarantees by creditworthy parties of the performance and financial obligations under the advisory agreement. Organizers, equityholders or other stakeholders of a newly formed counterparty are logical candidates in that situation. In Alliance Data Systems Corp. v. Blackstone Capital Partners v. L.P., C.A., No. 3796-VCS, mem. op. (Del. Ch. Jan. 15, 2009), the Delaware Court of Chancery reaffirmed that in a typical private equity firm transaction structure, a non-signatory private equity firm will not have liability for failure of its newly formed shell corporation to consummate a transaction. In other words, you can't rely on a non-party, even if they are the people you are dealing with on the transaction. This should also be considered in today's environment of financially troubled portfolio companies.
• Arrange for assumption of obligations. In the shell counterparty situation, it may also be desirable for an advisor to obtain a commitment from the counterparty to cause the assumption of the obligations under the advisory agreement as part of any transaction or agreement involving the counterparty and a third party operating company. For example, in a management buyout it may be possible for the management team, who through a shell corporation has entered into an advisory agreement with a financial advisor, to effect the assumption of the obligations to the advisor as part of an agreement with the operating company to cover other deal expenses, either at the letter of intent stage or the definitive agreement stage. Yet if an uncreditworthy promisor fails to live up to its covenant to cause assumption, no remedy is likely to lie against anyone other than that same uncreditworthy party.
• Draft transaction description broadly. Advisors, especially on the buyside, should be sensitive to the possibility that an acquisition may not be effected by the party with which it has contracted, but rather an affiliate, joint venture entity or other related entity. In such instances, the description of the "transaction" for which compensation is to be paid should be drafted in such a way as to include a broad range of potential acquirers who have a relationship with the advisor's counterparty.